The effects of Macroprudential Policy on Crisis Risk

Abstract

The ultimate goal of macroprudential policy is to prevent and reduce the costs of systemic financial crises, therefore contributing to promoting sustainable economic growth. However, despite the active role played by this policy in the last decades, there is still limited empirical evidence showing whether prudential regulation is effective at enhancing financial stability through the prevention and mitigation of crisis risk. This paper aims to close this gap by studying the relationship between macroprudential policy and both the likelihood and severity of financial crises. The contribution of the paper is twofold. First, I show that tightening macroprudential policies are successful at reducing the frequency of systemic financial crises. Moreover, this result holds even if macroprudential policies are implemented when the economy is already experiencing a financial boom or when monetary conditions are rather accommodative. I point to the prevention and mitigation of financial booms as the main transmission mechanism through which macroprudential policy defuses crisis risk. Second, I find that preventive macroprudential policy enhances the resilience of the financial system, hence dampening the output losses associated with future systemic financial crises. The latter result implies that macroprudential policy not only makes financial crises less likely but also less painful.